Tuesday, 26 February 2013

Finance minister must strike a balance between poll pressures and imperatives of reform

When Finance Minister P. Chidambaram stands up to present Budget 2013 later this week, he will have to walk a tightrope between a budget that makes investors optimistic about India and one that satisfies his party, especially those in the Congress who want welfare programmes and subsidies. In Chidambaram's earlier stint as finance minister, walking this tightrope was not as difficult as it is today because the economy was growing fast, the fiscal deficit was under control and the current account deficit was much smaller than it is today.

The forthcoming budget is expected to be the last one this government can present. Next year, there might be a vote on account, in view of the elections that will follow soon after. That makes this budget the last chance for the UPA to fulfil all the election promises it made. If Congress MPs feel that they are not going to win the next elections, the desperation to expand welfare programmes will only increase. This could involve a stepping up of expenditure, which the government can ill afford at the moment.

Introducing new programmes like the food security bill, or continuing old programmes and increasing expenditure on them, needs money. With a slowing economy, tax revenue growth is unlikely to be buoyant. Even if the finance minister tries to come up with proposals to tax the rich more, it is unlikely that he will raise much revenue from them. Further, even if he is able to introduce the GST, revenues might not go up in the first year. Infrastructure issues, compensation to states for Central sales tax cuts, and the costs of implementing the new system will mean that he cannot depend on higher tax revenues in the coming year.

So will Chidambaram project a higher budget deficit? No, because that would be a problem with domestic and foreign investors. Consequences of the fiscal deficit, such as higher inflation, private investment being crowded out by large government borrowing and the spillover to the external sector, remain concerns, as in the past. What is new, perhaps, is how close we are to a credit downgrade. If credit rating agencies believe that our fiscal deficit is going to be higher in the coming year, India could get a downgrade. That would push up the interest rate Indian companies have to pay when they borrow abroad.

The domestic banking sector, with its rising number of non-performing assets and loan restructuring, has seen its balance sheets weaken. External loans remain an important source of borrowing for large corporations. Domestic interest rates are also unlikely to come down very much unless inflation goes down, of which there are few signs so far. Unlike in previous years, when the size of the fiscal deficit was an academic debate rather than something that bites the corporate sector, it is different this time.

If Chidambaram is under pressure to increase expenditure in some areas, as his party desires, he has to cut expenditure in others. The freeing up of diesel prices has been an important development in curtailing expenditure. First, it has indicated Chidambaram's commitment to containing expenditure on oil subsidies. Second, the price hike passed relatively peacefully, without creating a political storm, as most people might have expected. This bodes well for the finance minister's plans. He can make projections of not just the oil subsidy going away in the coming year but also of other subsidies going down to provide, for example, for an increase in food subsidy.

The second major concern of business is the investment environment. While Chidambaram set up the Cabinet Committee on Investment a few months ago to speed up stalled projects, investors have not seen any action on that front. It has not inspired confidence and encouraged investment again. With no change in the legal framework, few believe that a government committee could solve the problems. However, many were willing to give Chidambaram the benefit of doubt, and to wait and watch. Here again, we run into trouble with politicians in the party who might want to say they stand for tribal rights, environment and land rights, much more than they would have when not faced with an upcoming election. If legal changes are proposed this year, they may not be in keeping with the kind of balance that India needs to strike between development and the protection of various affected groups. If they are not proposed, investors will continue to have low confidence.

A major concern of the minister would be to keep foreign capital coming in to fund India's large and growing current account deficit. One small mistake in the couple of hours when Chidambaram makes his speech could cause a loss of confidence, months of flight of foreign capital and a depreciation of the rupee. It could be new foreigner unfriendly taxes, such as the GAAR of last year. It could be a capital gains tax, since in India, taxes are not residence based and foreigners are taxed. Or the budget speech could talk about renegotiating the Mauritius double taxation treaty. Or it could be something else that the zealous tax department thinks of in its attempt to reduce the budget deficit. Any tax on capital inflows, at a time when the country needs to finance its current account deficit by attracting them, would not be pragmatic.

Not only does Chidambaram need to be careful about taxing foreigners, Part A of the budget speech, which is the government's reform agenda, has to be persuasive, investor-friendly and inspire confidence. Part B of the speech, which includes his tax and expenditure proposals, has to keep the deficit under control and his party colleagues happy.

With a non-performing government, a party seeking to buy votes, a declining economy, an uncertain global environment, persistent inflation, a large deficit and colleagues wanting an election-friendly budget, Chidambaram clearly has a tough job ahead.

Tuesday, 12 February 2013

Arguing over GDP numbers won't convince investors. Government must focus on fiscal correction

The ministry of finance has responded strongly to the Central Statistics Office (CSO) estimates for GDP growth of 5 per cent in 2012-13, saying that it is an underestimation. Normally, it would be surprising to see the ministry respond to growth numbers as loudly as it has done this time. But in this case, it was not entirely unexpected. The CSO's estimates can upset the finance ministry's promise of a lower fiscal deficit number. On his recent foreign tour, Finance Minister P. Chidambaram promised a 5.3 per cent budget deficit. This rests not only on projections of revenue, expenditure and the gap between them, but also on the denominator, GDP.

All the important assumptions made in the projections for the 2012-13 budget deficit have gone awry. During April-October, tax revenues grew by 14.54 per cent. This was lower than the 20 per cent growth assumed in the budget. Expenditure growth, at 14.6 per cent, on the other hand, was higher than the 13 per cent expenditure growth.

The fiscal situation is already difficult. With unmet disinvestment targets, a large subsidy bill that has yet to be impacted much by higher fuel prices and a newly launched cash transfer scheme that is unlikely to give efficiency gains or any reduction in expenditure in this budget, cutting expenses on the big ticket items is not easy. The finance ministry's credibility is already fragile. The CSO's GDP estimates can further hurt it. A smaller GDP number will yield a higher fiscal deficit to GDP ratio.

Under the current system of budget making, the government makes an assumption of GDP growth while preparing estimates for the budget. The ministry has insisted that growth will be 5.5 per cent. Since these are all only projections of production in the economy till March 31, 2013, it is surprising how anyone can be very confident about what GDP growth is going to be. Indeed, during the last two years, most projections of GDP growth for India have been slashed. The IMF's projection for GDP growth for India in 2012 is 4.5 per cent. Looking at the relentless decline in investment growth, it seems a more plausible estimate than the ministry of finance's 5.5 per cent. Even if the ministry is seeing green shoots of recovery, none of the publicly available indicators show them yet.

As it is natural for the government to try to show a low ratio for the fiscal deficit, it has the incentive to choose an implicit GDP growth rate that is higher, making the budget deficit ratios smaller. The best way to address this issue is to set up an independent panel to provide GDP forecasts.

Today, there are a number of independent forecasts for the Indian economy being made by those monitoring the economy. In general, these forecasters are conservative in that they tend to move with the consensus and their assessment may not be very far from what the government itself is saying. However, to the extent that they are not conflicted, in that they are not producing the budget revenue and expenditure decisions and the deficit ratios, the forecasts they produce are independent. These should go into the budget process.

Chidambaram has made an effort to cut expenditure and raise revenues in the last few months. Many positive steps, especially where policy decisions were in his hands, have been taken. The significance of cutting the deficit and its impact on the economy is high at this moment. A clue lies in the fact that the FM undertook a foreign tour to reassure foreign investors at a time when he would normally be busy with the details of the budget. The macro picture of the budget is extremely important today and that is why, perhaps, the ministry responded so strongly to the CSO estimates.

The reasons for the importance of the macro picture lie in the difficulties currently being faced on the balance of payments. India has had a large current account deficit of 5.4 per cent of the GDP. This means India needs to keep up an inflow of capital despite falling growth and worsening public finances. This can be done if foreigners are assured that in the long run, India is a good investment opportunity, that India is on the path of implementing reforms that will ensure a strong currency. A decline in capital flows can cause a rupee depreciation. A rupee depreciation would put further pressure on the fuel subsidy bill as the price of every barrel of imported oil will increase. Further, it will put pressure on domestic prices. While it is unlikely that a small change in the fiscal deficit number would stop foreign capital from flowing into India, it shapes views on future current account deficits and the strength of the rupee.

In addition, a large fiscal deficit could cause a ratings downgrade for India. This would increase the cost of borrowing by Indian companies abroad. Domestic credit growth has declined. Banks are reluctant to lend because their own balance sheets are not looking healthy. External financing is relatively cheaper, but only so far as the credit rating is good and the rupee is not expected to depreciate. Both these require the fiscal deficit to remain low.

A slightly higher denominator in the budget deficit to GDP ratio may appear good in the immediate context. But if the health of India's fiscal condition does not improve, no one is going to be fooled for long. The difficulty may get worse if the current account balance does not improve. Instead of focusing on how to defer the bad news, the government needs to focus on how it will actually do a fiscal correction. If the government is going to introduce the Food Security Act, there should be a clear indication of what it means for this year's and the following year's government expenditure. Unless such careful analysis is done of various government programmes, no amount of relatively good news obtained by arguing over GDP figures is going to convince any investor that India is worth the risk.

Tuesday, 5 February 2013

Does the UPA government believe that the public distribution system is broken and cash transfers are needed, or does it believe that the PDS works well and can serve a multiple of the numbers it is currently catering to?

In the budget session of Parliament, the government is expected to further push subsidy expenditure through cash transfers. In the same session, it is expected to table the food security bill. Surely, it is clear that there is a contradiction between the philosophy of the two. The strategy of cash transfers, when it means giving money to poor households to bring them above the poverty line, is based on the philosophy that households should be free to choose what they buy. Providing subsidised cereal to households is a policy that is based on the notion that it is best if the state decides what is good for the people and provides it. It is unlikely that in the mind of this government, that has not yet clearly articulated the full policy, cash transfers are designed to be like a negative income tax where freedom of choice is given to the individual and the family, which can buy what it chooses to. A badly designed cash transfer scheme would be one linked to consumption of specific items - food, education, kerosene, fertiliser, etc. Under this scheme, the choice of where to buy would lie with the household.

Currently, cash transfers are limited to a few small items like scholarships and pensions. They can be kept limited to these items and incrementally expanded to include a few more. Or, they could be expected to cover all subsidies, where an income subsidy amount is paid directly to the beneficiary, rather than through a price subsidy on particular items. If the logic of cash transfers was to be carried forward, each poor household would be given a sum to money to pull it above the poverty line. Like an income tax, which is paid by better-off households to the government, this would be a benefit or a "negative income tax" the government pays to households.

Giving poor households money is based on the belief that no one understands the needs and priorities of the household better than the individual and her family. If she chooses, a person below the poverty line could pay for the transport that takes her to a hospital instead of buying 10 kg of rice. Cash transfers are genuinely meaningful if they become the main plank of a government's anti-poverty programme. If it is one of many programmes, then it has a marginal impact on both efficiency and government expenditure.

Cash transfers in, say, scholarships or pensions, can only solve the problem of delay in payments. If combined with Aadhaar, there will be some additional saving for the government, as ghost and duplicate beneficiaries can be removed from the system. This might save as much as 10 to 15 per cent of the expenditure under that head. The big savings through cash transfers can come if, instead of paying a price subsidy, say on wheat, the government could transfer money directly to a family to buy a minimum consumption bundle to rise above the poverty line. That would enable the government to get rid of a large number of price subsidies, such as those on kerosene, LPG and food. Families would then buy these directly at market prices. The theft and wastage from the public distribution system would go away.

The food security bill, as proposed to be tabled, is based on a completely different philosophy. Not only does it assume that it is best for the poor in India to eat wheat and rice - instead of pulses, fish, vegetables, eggs or milk - it also assumes that the state will handle the purchase, storage and sale of this wheat and rice better than the market can. It assumes that this wheat and rice (often rotting, as it is stored in the open due to the shortage of warehouses with the Food Corporation of India) will be bought by the people. It assumes that people are not buying large quantities of wheat and rice because the price is too high, and that once it is supplied by the government at a low price, they are going to buy it.

Several assumptions about individual preferences are being made here. It is being assumed that the behaviour observed in household data that shows that diversity in food, and particularly the preference for protein such as dal, eggs, fish, chicken and meat, does not hold true or will not hold true as incomes rise. But the evidence suggests otherwise. In the last few years, there has been an increase in the price of proteins and some observers have linked the price rise to the increase in demand resulting from rural incomes going up. On the other hand, cereal prices have not been the fastest growing prices. The prices of non-cereal food items have grown the fastest, reflecting growing demand.

In addition to the issue of preferences is the problem of leakages from the PDS. The problem is well known and understood to be large. Many committees have suggested shutting the PDS down and replacing it with food vouchers. If the bill is passed, then for providing 67 per cent of the population some 50 million tons of cereals, the PDS will have to be expanded.

The answer to why the government is moving in two opposite directions does not appear to lie in the political beliefs or philosophy of the Congress. Maybe it lies in the strategy of providing goodies to voters in whatever way possible. If the strategy works and the Congress is voted back to power, the food security act will likely become one of the biggest headaches of the next government. Instead, the government should focus on fiscal consolidation and growth in this budget, and not promise more money down leaky pipes.